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There´s no “secular stagnation”, it´s about misguided monetary policy

Larry Summer made a splash with his closing speech at the IMF Conference. That was probably his intention following him being denied the Fed Chair.

Several people have taken turns both critiquing and asserting his “secular stagnation” thesis. I think the most straightforward critique was Ryan Avent´s “The solution that cannot be named”:

I think it’s important and welcome for someone of Mr. Summers’ stature to point out how serious a problem the zero lower bound is and to note that it is not going away any time soon. But this discussion sorely needs a dose of real talk, and soon. Or nominal talk, I should say.

Just why the real natural rate of interest is so low is an interesting question. Maybe it’s down to a global savings glut, spurred by emerging-market reserve accumulation and exchange-rate management. Maybe it is a transitory symptom of widespread deleveraging. Maybe its roots are more structural in nature: a product of demographic or technological trends. I have my own suspicions, but the important thing to point out is that for the purpose of this discussion and this crisis it doesn’t matter.

The zero lower bound is a nominal problem. However low the real interest rate, an economy can keep nominal rates safely in positive territory by running a sufficiently high rate of inflation. Back in August, another eminent economist, Robert Hall of Stanford University, contributed a paper on the zero lower bound to the Kansas City Fed’s Jackon Hole conference, in which he estimated that the market-clearing real rate of interest is -4%. Now again, just why the real, natural rate of interest is currently -4% is an interesting question, but it’s irrelevant to the challenge of closing the output gap. All that matters there is that expected inflation is between 1% and 2% instead of near 4%. That’s the problem; that’s what’s keeping tens of millions of people out of work and hundreds of millions languishing in a perpetually weak economy: a couple of percentage points of inflation.

And central banks are entirely to blame for that.

My purpose is to illustrate the shortcoming of monetary policy that began almost as soon as Bernanke took over at the Fed. The set of three charts give, I think, a good visual of what went on since 1987.

In his post Ryan Avent concludes:

The belief in the critical importance of low and stable inflation is more flexible than the gold standard was, and it is born of a better understanding of the workings of the macroeconomy. But it is a binding constraint on recovery and prosperity all the same. And the unwillingness to question its continued utility in the face of evidence that it is doing real harm looks all too similar to the intellectual fetters that led central bankers to persist in foolish policy in the early 1930s.

RA argues in terms of inflation (or expected inflation). But you don´t need to do so. Much better to frame things in terms of nominal spending or NGDP. The charts above should help convince some people.

Note: What gave rise to the oil shock of 2002-08, when oil price increased by a factor of 6?

One candidate is the demand pressure from Chinese imports which rose by a factor of 5 during the same period, which coincides with China becoming a member of the WTO! Chart below.

Note 2: The chart below indicates that nominal and real rates have been trending down since inflation was “crushed” by Volcker and kept low and stable thereafter. So what?

The Fed’s decision in the final month of 2008 to lower its overnight target rate to essentially zero percent appears to have “unwittingly committed the U.S. to an extremely long period at the zero lower bound similar to the situation in Japan, with unknown consequences for the macroeconomy,” Mr. Bullard said.